419, 412i, plans are being audited by the IRS. Lawsuits are the result.
Dolan Media Newswires 01/22/
Small Business Retirement Plans Fuel Litigation
Small businesses facing audits and potentially huge tax penalties over certain types of retirement plans are filing lawsuits against those who marketed, designed and sold the plans. The 412(i) and 419(e) plans were marketed in the past several years as a way for small business owners to set up retirement or welfare benefits plans while leveraging huge tax savings, but the IRS put them on a list of abusive tax shelters and has more recently focused audits on them.
The penalties for such transactions are extremely high and can pile up quickly - $100,000 per individual and $200,000 per entity per tax year for each failure to disclose the transaction - often exceeding the disallowed taxes.
There are business owners who owe $6,000 in taxes but have been assessed $1.2 million in penalties. The existing cases involve many types of businesses, including doctors' offices, dental practices, grocery store owners, mortgage companies and restaurant owners. Some are trying to negotiate with the IRS. Others are not waiting. A class action has been filed and cases in several states are ongoing. The business owners claim that they were targeted by insurance companies; and their agents to purchase the plans without any disclosure that the IRS viewed the plans as abusive tax shelters. Other defendants include financial advisors who recommended the plans, accountants who failed to fill out required tax forms and law firms that drafted opinion letters legitimizing the plans, which were used as marketing tools.
A 412(i) plan is a form of defined benefit pension plan. A 419(e) plan is a similar type of health and benefits plan. Typically, these were sold to small, privately held businesses with fewer than 20 employees and several million dollars in gross revenues. What distinguished a legitimate plan from the plans at issue were the life insurance policies used to fund them. The employer would make large cash contributions in the form of insurance premiums, deducting the entire amounts. The insurance policy was designed to have a "springing cash value," meaning that for the first 5-7 years it would have a near-zero cash value, and then spring up in value.
Just before it sprung, the owner would purchase the policy from the trust at the low cash value, thus making a tax-free transaction. After the cash value shot up, the owner could take tax-free loans against it. Meanwhile, the insurance agents collected exorbitant commissions on the premiums - 80 to 110 percent of the first year's premium, which could exceed $1 million.
Technically, the IRS's problems with the plans were that the "springing cash" structure disqualified them from being 412(i) plans and that the premiums, which dwarfed any payout to a beneficiary, violated incidental death benefit rules.
Under Â§6707A of the Internal Revenue Code, once the IRS flags something as an abusive tax shelter, or "listed transaction," penalties are imposed per year for each failure to disclose it. Another allegation is that businesses weren't told that they had to file Form 8886, which discloses a listed transaction.
According to Lance Wallach of Plainview, N.Y. (516-938-5007), who testifies as an expert in cases involving the plans, the vast majority of accountants either did not file the forms for their clients or did not fill them out correctly.
Because the IRS did not begin to focus audits on these types of plans until some years after they became listed transactions, the penalties have already stacked up by the time of the audits.
Another reason plaintiffs are going to court is that there are few alternatives - the penalties are not appealable and must be paid before filing an administrative claim for a refund.

The suits allege misrepresentation, fraud and other consumer claims. "In street language, they lied," said Peter Losavio, a plaintiffs' attorney in Baton Rouge, La., who is investigating several cases. So far they have had mixed results. Losavio said that the strength of an individual case would depend on the disclosures made and what the sellers knew or should have known about the risks.
In 2004, the IRS issued notices and revenue rulings indicating that the plans were listed transactions. But plaintiffs' lawyers allege that there were earlier signs that the plans ran afoul of the tax laws, evidenced by the fact that the IRS is auditing plans that existed before 2004.
"Insurance companies were aware this was dancing a tightrope," said William Noll, a tax attorney in Malvern, Pa. "These plans were being scrutinized by the IRS at the same time they were being promoted, but there wasn't any disclosure of the scrutiny to unwitting customers."
A defense attorney, who represents benefits professionals in pending lawsuits, said the main defense is that the plans complied with the regulations at the time and that "nobody can predict the future."
An employee benefits attorney who has settled several cases against insurance companies, said that although the lost tax benefit is not recoverable, other damages include the hefty commissions - which in one of his cases amounted to $860,000 the first year - as well as the costs of handling the audit and filing amended tax returns.
Defying the individualized approach an attorney filed a class action in federal court against four insurance companies claiming that they were aware that since the 1980s the IRS had been calling the policies potentially abusive and that in 2002 the IRS gave lectures calling the plans not just abusive but "criminal." A judge dismissed the case against one of the insurers that sold 412(i) plans.
The court said that the plaintiffs failed to show the statements made by the insurance companies were fraudulent at the time they were made, because IRS statements prior to the revenue rulings indicated that the agency may or may not take the position that the plans were abusive. The attorney, whose suit also names law firm for its opinion letters approving the plans, will appeal the dismissal to the 5th Circuit.
In a case that survived a similar motion to dismiss, a small business owner is suing Hartford Insurance to recover a "seven-figure" sum in penalties and fees paid to the IRS. A trial is expected in August.
Last July, in response to a letter from members of Congress, the IRS put a moratorium on collection of Â§6707A penalties, but only in cases where the tax benefits were less than $100,000 per year for individuals and $200,000 for entities. That moratorium was recently extended until March 1, 2010.

But tax experts say the audits and penalties continue. "There's a bit of a disconnect between what members of Congress thought they meant by suspending collection and what is happening in practice. Clients are still getting bills and threats of liens," Wallach said.

"Thousands of business owners are being hit with million-dollar-plus fines. ... The audits are continuing and escalating. I just got four calls today," he said. A bill has been introduced in Congress to make the penalties less draconian, but nobody is expecting a magic bullet.

"From what we know, Congress is looking to make the penalties more proportionate to the tax benefit received instead of a fixed amount."

Lance Wallach, National Society of Accountants Speaker of the Year and member of the AICPA faculty of teaching professionals, is a frequent speaker on retirement plans, abusive tax shelters, financial, international tax, and estate planning. He writes about 412(i), 419, Section79, FBAR and captive insurance plans. He speaks at more than ten conventions annually, writes for more than 50 publications, is quoted regularly in the press and has been featured on television and radio financial talk shows including NBC, National Public Radioâs âAll Things Consideredâ and others. Lance has written numerous books including âProtecting Clients from Fraud, Incompetence and Scams,â published by John Wiley and Sons, Bisk Educationâs âCPAâs Guide to Life Insurance and Federal Estate and Gift Taxation,â as well as the AICPA best-selling books, including âAvoiding Circular 230 Malpractice Traps and Common Abusive Small Business Hot Spots.â He does expert witness testimony and has never lost a case. Contact him at 516.938.5007, or visit taxadvisorexpert.com.
The information provided herein is not intended as legal, accounting, financial or any type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

Case law defines a captive insurance company as a "wholly owned insurance subsidiary." In less formal language, a captive is an insurance company that you own.

Why Would I Form a Captive?

To cover risks that aren't covered by traditional insurance polices

Aren't My Current Policies Adequate?

Probably not. Most commercially available policies have significant and well-known exemptions.

How Long Have Companies Been Doing This?

The first captives were formed in the 1950s because companies couldn't find insurance coverage for certain risks. The practice is now widespread; there are more than 5,000 captives worldwide and over 30 US states have legislation allowing for the formation of a captive insurance company.

IRS Hiring
Agents in
Abusive
Transactions
Group
Here it is. Here is proof of my predictions. Perhaps you
didnât believe me when I told you the IRS was coming after
what it has deemed âabusive transactions,â but here it is,
right from the IRSâs own job posting website: âIf you or
your clients were involved with a 419, and you havenât yet
approached an expert for help, you had better do it now,
before the notices start piling up on your desk.â
Specific forms need to be properly filed under IRC Section
6707A to avoid large IRS fines. These fines are in addition
to IRS audits and disallowances of tax deductions. With this
tactic, the IRS gets your client twice. First, they get audited
and their tax deduction gets disallowed with possible
interest and penalties. Then the IRS comes after your client
again for not properly filing forms under Internal Revenue
Code 6707A. The resulting fines for not properly filing are
large, but they can usually be avoided by properly filing the
required forms. Here is a small portion of the job posting I
referred to above:
Job Title: Internal Revenue Agent
(Abusive Transactions Group)
Agency: Internal Revenue Service
Open Period: Monday, October 18, 2010, to Monday,
November 1, 2010
Sub Agency: Internal Revenue Service
Job Announcement Number: 11PH1-SBB0058-0512-12/13
Who may be considered:
â¢ IRS employees on career or career conditional
appointments in the competitive service;
â¢ Treasury Office of chief counsel employees on career
or career conditional appointments or with prior
competitive status; and
â¢ IRS employees on term appointments

The IRS release (IR-2015-19) states that while captive insurance companies can be a legitimate tax structure, certain closely held entities may be persuaded by âunscrupulous promotersâ to create captive insurance companies. The captives are intended to qualify as small insurance companies under Code section 831(b). Under that section, small insurance companies are taxed not on their premium income, but on their investment income.

The IRS stated that these promoters assist with creating and âsellingâ to the entities poorly drafted âinsuranceâ binders and policies to cover ordinary business risks or esoteric, implausible risks for exorbitant âpremiums,â while maintaining their economical commercial coverage with traditional insurers.

The total amounts of annual premiums often equal the amount of deductions business entities need to reduce income for the yearâor, for a wealthy entity, total premiums amount to $1.2 million annually to take full advantage of the Code provision. Underwriting and actuarial substantiation for the insurance premiums paid are either missing or insufficient. The promoters manage the entitiesâ captive insurance companies year after year for hefty fees, assisting taxpayers unsophisticated in insurance to continue the charade.

CPAs and their clients should bear in mind that the stakes are high. If the IRS finds that the captive insurance company doesnât pass muster, it means losing not only the premium deduction, but also incurring a 20 percent penalty, along with interest. Moreover, the IRS is now also considering imposing economic substance penalties as well (the 20 percent goes to 40 percent).

The best practice we believe for CPA firms with clients with captive insurance companies is to have a review conducted to ensure that the captive is conforming to tax law requirements both in form and substanceâand a deep look especially at the insurance provided and the overall insurance pool. Obviously, this is best done before the IRS comes knocking on the door. The risks of adverse IRS action can be managed if done proactively on a voluntary basis.

If your client is already hearing from the IRS, have your eyes open that this is a highly technical area of tax law and involves a detailed understanding and knowledge of insurance questions from a tax law perspective. The fact that captive insurance is on the âDirty Dozenâ list means you can anticipate a thorough audit that is closely managed by technicians and senior officials at the IRS.

Our success with clients has come from not only having a good understanding of the IRSâs concerns and priorities, but also from what we have seen in a number of cases. In our experience, the key is knowing what the IRS is willing to accept, when the IRS is willing to let the taxpayer correct and what it takes to resolve an examination.

CPAs play a vital role as the most trusted financialadvisor for many small and medium companies. For CPAs with clients with captive insurance companies, now is the time to tell their client they are in deep watersâand help assist them in coming safely to shore.

Notice 2016-66 â Section 831(b) Micro-Captive Transactions. Micro-captive arrangements described in the Notice became a reportable transaction on November 1, 2016. This Notice identifies as a transaction of interest the micro-captive transaction where a taxpayer enters into a purported insurance contract with a captive insurance company (âCaptiveâ), or a purported reinsurance contract with a Captive through an intermediary insurance company, and where a Captive is at least 20 percent owned by the taxpayer or/and related parties. In addition, the micro-captive transaction has one or both of the following characteristics: 1) the amount of Captiveâs liabilities for insured losses and claim administration expenses is less than 70 percent of the Captiveâs earned premiums less paid policyholder dividends, or 2) Captive made available through a guarantee, a loan, or other transfer of Captiveâs capital, any portion of payments received under contracts to the taxpayer or its owners. The taxpayer, an âinsuredâ entity under the contract, claims ordinary deductions for purported insurance or reinsurance premiums while a Captive elects under Â§ 831(b) of the Internal Revenue Code to be taxed only on investment income. Captive excludes the payments directly or indirectly received under the contracts from its taxable income.

Notice 2017-8 â Section 831(b) Micro-Captive Transactions, amends the due date for filing of a disclosure with the Office of Tax Shelter Analysis for Notice 2016-66 transactions.